Pressure on Fortescue to intensify as iron ore prices deteriorate
At face value, the forecast 1000% uplift in Fortescue Metal Group's (ASX: FMG) intrinsic value looks impressive, but even if it does soar from $0.04 in 2016 to $0.50 in 2017, the big-cap miner still looks chronically overvalued relative to the current share price ($1.85). With much of the iron ore pure-play's fortunes wired to falling prices – expected to go sub-$US40 a tonne later this year – amid weak demand and increasing supply, it's easy to argue why a bearish share price outlook outweighs the upside going forward.
As much as the 'true-believers' may like the Fortescue story, the stock's current situation, and the quality of its balance sheet should remind investors why it's not a good idea to buy 'falling daggers' – they typically inflict a lot of pain.
Optimists clearly took some solace in the recent iron ore price rally – up around $US56 a tonne – but the prevailing view suggests the 'technical bull market' for iron ore will quickly run out of steam, and this explains why the share price is 28% down on the $2.57 it was trading at mid to early May.
Due to some impressive production and cost containment – with costs down 14% to US$22 a tonne in the fourth quarter of 2015 – Fortescue's break-even cost is now around $US39 a tonne. But an anticipated fall below $US40 later this year means Fortescue won't be making any money. Equally concerning is how long Fortescue could ride-out production below a break-even cost at those levels.
Admittedly, with a cash flow ratio of 2.32, Fortescue's long-term cash flow relative to reported profits is strong. But the $7.9 billion long-term funding gap which continues to plague the company is understandably of concern to the market, and any price deterioration intensifies concerns over future repayment.
While Fortescue's return on equity (ROE) has averaged 20.45% since 2005 – recently ROE hit 41.57% (2014) – it is forecast to fall to 5.94% in 2015, and then 0.23% and 3.66% in 2016 and 2017 respectively. As a result, earnings per share (EPS) – which has experienced exceptional growth over the last five years – is expected to deteriorate from $0.92 in 2014 to $0.16 in 2015, and $0.01 and $.10 in 2016 and 2017 respectively.
Despite vigorous attempts by management to convince the market otherwise, there's growing concern among the investment and analyst community that Fortescue is rapidly becoming a 'marginal' large iron ore producer, and given current dynamics this claim seems to hold water.
In the meantime, the plight of Fortescue may make it increasingly attractive to cashed-up foreign buyers that have been circling Australia's distressed iron ore assets for some time. It's understood the Foreign Investment Review Board (FIRB) has received numerous applications in recent months from foreign companies looking to buy Australia's iron ore assets, and Fortescue is well and truly on their radar.
While Fortescue is currently trading at a low unseen since late 2008, now is not the time to be second-guessing the direction of iron ore prices. Expect further weakness.